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Stocks drop as inflation data surges, interest rates rise

Nobody can predict interest rates, the future direction of the economy or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you have invested. – Peter Lynch

Despite mostly better than expected earnings from the big money center banks last week, the major stock averages all closed lower with the technology-heavy Nasdaq Composite Index suffering the worst decline as expensive growth stocks fell as interest rates continued to rise. The Dow Jones Industrial Average was the relative winner with a loss of less than 1% while the S&P 500 Index dropped about 2%. First quarter earnings season began on Wednesday with JP Morgan and the company beat earnings and revenue estimates but its profit fell by 42% due to market dislocations from sanctions against Russia. Management also announced that it was adding to its credit reserves because of potential risks to the economy. Goldman Sachs, Morgan Stanley and Citigroup followed with revenue and earnings results that topped expectations as trading revenue was stronger than expected. However, worrisome inflation data, higher interest rates, the war in Ukraine and the prospect of more Federal Reserve tightening all combined to increase the level of uncertainty and weighed on investor sentiment. The consumer price index (CPI) in March rose 8.5% from a year ago, the fastest annual pace since December 1981, and slightly above expectations. While the core rate of inflation that excludes food and energy prices was less than expected and appeared to be moderating, it provided little solace to consumers who must eat and drive to work every day. Wholesale prices in March as measured by the producer price index (PPI) also surged and the data set a record going back to 2010 when records were first kept. As a result of the high inflation data, the markets are now pricing in a 50 basis point (a basis point is one hundredth of one percent) interest rate hike by the Federal Reserve in May and additional hikes until the federal funds rate hits 2.5% by the end of the year. In response to the potential rate hikes to curb inflation, the yield on the 10-year Treasury rose to 2.81% while the yield on the 2-year Treasury settled at 2.47%, indicating that the yield curve is positive sloping again and no longer inverted, a sign of a possible recession.

Last Week

The modest rise in the core CPI index in March suggested that inflation may be peaking, but the PPI data released the next day showed that prices rose 1.4% in March and 11.2% from a year ago, both higher than expected. Import prices in March were also higher than forecast and showed the biggest increase since April 2011. Retail sales in March rose less than expected and the biggest gain came from gasoline sales. Weekly jobless claims rose to 185,000, an increase of 18,000 from the previous week and above estimates. The University of Michigan consumer sentiment index in April was much higher than expected and higher than the March reading as gas prices have fallen slightly from their highs in March.

For the week, the Dow Jones Industrial Average fell 0.8% to close at 34,451 while the S&P 500 Index declined 2.1% to close at 4,392. The Nasdaq Composite Index dropped 2.6% to close at 13,351.

This Week

March housing starts are expected to approximate those in February, which were the highest since June 2006, while March existing home sales are forecast to be less than in February and the lowest since June 2020. The leading economic indicators for March are expected to increase modestly as gross domestic product (GDP) is projected to rise about 3% for the year.

The most notable companies scheduled to report their first quarter earnings this week include Bank of America, Bank of New York Mellon, Charles Schwab, Travelers, American Express, IBM, Netflix, Tesla, Abbott Labs, Johnson & Johnson, Lockheed Martin, CSX, Dow, Alcoa, Nucor, Union Pacific, Baker Hughes, Halliburton, Schlumberger, Procter & Gamble, Kimberly-Clark, AT&T and Verizon.

Portfolio Strategy

Unlike the first week of earnings season which was dominated by banks and other financial companies, a more diverse group of companies from all sectors of the S&P 500 will report their earnings this week. First quarter earnings are expected to increase about 6% and most companies that report this week will likely top expectations, although not by as much as in previous quarters. The key for investors is what the companies say about their forward guidance on profits, which could be problematic due to the uncertainty with regard to the war in Ukraine, high inflation, rising interest rates and Federal Reserve monetary policy. The Fed meets again in early May and is expected to raise the federal funds rate by a half of one percent and begin to reduce its massive holdings of Treasuries, Federal Agency issues and mortgage-backed securities. These moves are designed to tighten policy in order to reduce the high rate of inflation, which is at a level not seen in 40 years. The bond market has already priced in some of these policy moves as Treasury yields have soared since the beginning of the year and could move even higher. When the geopolitical risks of the war in Ukraine are also taken into account, it’s difficult to make a bullish case for the stock market given the number of headwinds it faces over the near-term. Surging inflation and higher interest rates are likely to slow the economy but the risk of recession still remains low over the next year. The stock market is likely to remain choppy and volatile over the next several months and remain in a trading range until many of these uncertain issues become clearer.